Tobacco.org

"A good settlement is one where everyone walks out of the room equally unhappy." Richard Scruggs, tobacco plaintiff counsel

1. Speculation that Republicans are now vulnerable on tobacco appears to be wishful thinking. Republican game plan appears to be for the House to pass a narrow drug/tobacco bill with no excise tax and limited FDA authority, and for the Senate to pass a bill similar to Hatch’s ($600b.+ payments/penalties) before the August recess. White House would then choose a plan in conference..

2. Republicans can derive political cover on tobacco from three places -- passage of legislation that directly addresses youth access, industry’s continuing $40 million ad campaign, and public’s cynical view that increasing the price of cigarettes is a way for the government to raise revenues, rather than curb teen smoking. This is main reason we believe Clinton may back new settlement.

3. House Republican bill will be introduced by Deborah Pryce (R-OH) after the July 4th recess (week of July 13), and is likely to contain these elements: 1) Elimination of tax deductibility of tobacco marketing expense; 2) Tough retail licensing and access provisions; 3) Raising minimum purchase age from 18-21; 4) Limited FDA authority; 5) Fines on teens caught buying cigarettes; 6) No excise tax hike; 7) No legal protections. We expect this to pass just before the August recess begins.

4. In the Senate, we believe Lott and Hatch will try to work behind the scenes with the White House and public health officials over the next few weeks to build support for Hatch’s comprehensive bill ($600 billion+, full FDA authority). Demise of McCain bill has to be a wake-up call for Democrats/public health that no comprehensive bill can pass without industry’s buy-in. If Clinton decides to play ball, Hatch’s bill could get 50 votes in Senate from mainstream Democrats and moderate/liberal Republicans.
5. We are not changing estimates; we currently assume a $.70/pack excise tax increase over five years ($.40./pack in 1999). We could increase MO and RN estimates by $.05/share per year cumulative if the narrow House bill became law. A Hatch-type bill may lead us to lower 1999 estimates by $.05-$.10/share, and $.05/year thereafter. For 1998, we may trim estimates by $.05/share each on MO and RN if there is no year-end trade load. We don’t see share buyback activity resuming until August at the earliest.
6. While we expect talk of a "Plan B" settlement for all 50 state AG claims to return to the front burner, fueled by plaintiff counsel involved, we doubt the industry would purse Plan B until after Congress adjourns (October 9), or until after the Washington state trial (begins 9/22). The industry believes it can win Washington, given prior favorable rulings limiting plaintiff’s claims.
7. The key events likely to drive valuations over the next few months:
• Engle Phase I class action trial, begins July 6 in West Palm, FL. Phase I should last four weeks -- jury will be asked to find liability and punitive damages multiplier. Case unlikely to be settled. Judge Kaye perceived as hostile in Broin.
• Congressional action: House takes up tobacco bill week of 7/13; Senate may take up consideration of Hatch bill w/o 7/27
• White House tobacco summit (Aug-Sept), likely to be led by VP Gore. Any hint of summit favors passage of Hatch proposal.
• Key rulings (any day): Richardson (Maryland) state class action; Frosina (New York) class action; 4th Circuit FDA ruling
• DOJ indictments (any time): Way for Administration to pressure Republicans to pass McCain-type tobacco bill.

INVESTMENT CONCLUSIONS

We reiterate outperform ratings on MO, RN, and UST. We expect tobacco stocks to move sideways until we get some resolution on how the White House plays the McCain defeat, and until we can assess the potential outcome of the Engle class action trial, which starts in two weeks in Florida, before a hostile judge. Any signal that the White House will push for a tobacco summit, or embrace the Hatch bill, would be very bullish. Our 6-12 month price targets remain MO $60, RJR $40, UST $40.

1. Engle class action trial. The event most likely to drive valuations near-term is the Engle class action trial in Florida, which is set to begin July 6th. Engle will be a three-part trial: Phase I will deal with common issues of liability and causation for all class members, including whether to assess a class-wide punitive damage multiplier that would be used if compensatory damages are awarded for individual claims to be heard in Phases II and III. Phase II, before the same jury, will be a single trial to determine individual causation and injury for six representative plaintiff class members, and whether to award compensatory damages. Phase III will involve separate trials for all outside class members, which could number 250,000 - 300,000, before separate juries. If the jury finds common issues liability in Phase I, the trial plan allows the jury to then determine whether punitive damages should be awarded, and if so, the ratio of punitive damages to compensatory damages to be used in Phases II and III. This trial plan could change, however, since the judge who developed the trial plan has since stepped down. The judge in the case is now our old friend Judge Kaye from the Broin trial (settled for $350 million), who we perceived as being generally hostile toward the industry. Florida is one of nine states where plaintiffs can collect damages even if more than 50% to blame, as occurred in the Widdick trial. Because the case involves potentially hundreds of thousands of Florida residents with smoking-related diseases and symptoms, and could be replicated across the country if other courts embrace the process, we expect investors to become increasingly anxious over this case while it progresses. The single Phase II trial for the six representative class members will likely begin right after the Phase I trial is completed, which should take about 4-6 weeks.

2. White House strategy on tobacco. The other key issue is trying to determine the White House strategy on tobacco in the aftermath of the McCain defeat. While White House advisers continue to hint that the Administration will use the lack of progress on tobacco as a weapon by which to punish Republicans at the polls in November, we perceive such a threat as mostly bark and no bite. One, we expect both the House and Senate to pass tough youth smoking bills that focus squarely on youth tobacco access, which the American public is likely to perceive as a more effective way to control teen smoking than the Administration’s chosen strategy of raising cigarette prices. Second, two separate polls -- one by the WSJ/NBC in April, and one completed by an independent political group this week, show that by a 2:1 margin, the public viewed the McCain bill as a means for the government to raise more money, rather than as a way to reduce teen smoking. As we have tried to say on numerous occasions, empirical evidence shows, and apparently the American public recognizes, that raising the price of cigarettes by $1.00 or even $2.00/pack will have little if any effect on teen smoking rates. If the House passes a bill that focuses on youth access -- cigarettes are moved behind counters, minimum purchase age is raised from 18 to 21, retailers are fined if caught selling cigarettes to minors, teens’ drivers’ licenses are taken away if caught repeatedly buying cigarettes -- we believe the Administration will have a hard time saying that the Administration plan as embodied by the McCain bill would have worked better than the Republican plan now passed, and therefore the Republicans should be voted out of office. Third, the industry has vowed to continue to run its $40 million ad campaign deriding the McCain bill -- as a kind-of insurance policy in case McCain’s bill is resurrected. Our guess is that the Administration will, in the end, conclude that it is better for Clinton and Gore to embrace a new comprehensive settlement for which they can take credit, than use the failed McCain tobacco bill as a campaign issue. As we have said before, President Clinton may want a tobacco deal to keep his poll numbers high for when the Lewinsky materials start flowing from Ken Starr’s office. We believe that VP Gore would actually be named as the broker for any tobacco summit, since Gore must begin to assemble a list of high-profile accomplishments to convince the American public that he is worthy of the Presidency in 2000.

Our sources say the House will begin deliberating its more narrow tobacco/drug bill when the House returns in mid-July. In the Senate, assuming Lott and the White House can cobble together the 50 votes needed (25 of 45 Democrats, 25-30 of 55 Republicans) to pass Hatch’s comprehensive bill before the August recess, a House-Senate "summit" tobacco conference could occur over the August recess, with final passage in September. Key provisions of the House bill are expected to be as follows:
• Elimination of deductibility of marketing expenses ($5.1 billion marketing budget, but $3.4 billion represents trade and consumer promotional allowances that can be redefined as price reductions)
• Tough retail licensing and access program (fines on retailers if caught selling to minors, all products go behind the counter)
• Increases the minimum purchase age from 18 to 21
• Limited FDA authority (not yet defined, but likely gives control over advertising content and placement)
• Penalties on youths caught buying cigarettes (raises all-in cost of teens, without affecting price paid by adults)
• No excise tax increase and no legal protections